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Interest capitalization is when the lender adds any unpaid interest to your loan balance. For example, if you deferred a $10,000 student loan for three months and $85 in interest added up while your repayments were paused, your balance would be $10,085 after interest capitalization.
This generally happens if you weren’t making full interest payments and made a change to your repayment plan.
Interest capitalization affects both the short- and long-term cost of your student loans.
Interest capitalization increases your loan balance when the unpaid amount gets added to the principal. Since interest is a percentage of your loan balance, having a higher loan balance increases your interest payments. With interest capitalization, you end up paying interest on interest.
In most cases, pausing your loan repayments typically doesn’t lengthen your loan term. So even without interest capitalization, you’d have to pay off the same amount in a shorter timeframe. But because interest capitalization increases your balance, you’ll have to pay even more than you owed before over a shorter period of time.
Pausing or making reduced repayments makes your loan more expensive, even without interest capitalization. This is because interest is based on your loan balance. As your balance decreases, so does your interest payments. If your balance stays the same or decreases at a slower rate, you’ll pay more in interest.
Interest capitalization can happen in the following situations:
Say you had a $20,000 Direct Subsidized Loan and a $20,000 Direct Unsubsidized Loan at a 5% interest rate. You took them both out six months before graduation and signed up for the 10-year Standard Repayment Plan after your six-month grace period was up, giving one year for interest to add up on the Direct Unsubsidized Loan.
Here’s how the two compare:
Direct Subsidized Loan | Direct Unsubsidized Loan | |
---|---|---|
Balance after grace period | $20,000 | $20,999.96 |
Monthly cost | $212.13 | $222.74 |
Total interest cost | $5,455.72 | $6,728.46 |
In this case, you’d pay $10 more per month and nearly $1,300 more in total interest because of interest capitalization.
There are a few ways to prevent interest from capitalizing on your student loans:
Interest capitalization is the reason why deferment, forbearance and income-driven repayments aren’t the cost-saving options they might seem to be at first glance. It increases both your monthly and total loan cost, and could make it more difficult to stay on top of your repayments if you were already struggling. You can learn more about how repayments work by reading our guide to student loans.
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